## Tuesday, July 28, 2015

### "Inflation pushes new borrowing up"

That's what I said yesterday: Inflation pushes new borrowing up.

Because things cost more than before. So if we don't change our habits, if we just keep doing the same portion of our spending on credit, then the dollar amount of that portion will rise with inflation. No mystery there.

If "we" happen to be the Federal government, our borrowing is similarly affected by inflation: If we just keep doing the same portion of our spending on credit, then the dollar amount of that portion will rise with inflation.

Federal government or no, there may be other reasons for our new borrowing to rise or fall. Reasons other than inflation. For example, we may choose not to keep doing the same portion of our spending on credit. I'm trying to separate out the inflation from these other reasons.

//

I want to start with FRED's FYGFD, Gross Federal Debt. Graph #1 shows the annual change in Gross Federal Debt, billions of dollars. I'm using it as a measure of the annual deficit of the Federal government:

 Graph #1: Year-to-Year Change in the Federal Debt, a Measure of Deficits.
You can look at this graph a couple different ways. You can say the numbers really start going up fast right around 1980. And that's true. But if we chop off everything since 1980 and look at the years before that ...

 Graph #2: Wow, the numbers really start going up fast around 1975!
... we might want to say "Wow, the numbers really start going up fast around 1975!"

But then, if we chop off everything after 1970 and look at what's left, we could say "Wow! the numbers really start going up fast around 1966!"

 Graph #3: Wow! the numbers really start going up fast around 1966!

And if you look again at that graph, you might happen to notice that the numbers were trending upward right from the start.

All these important facts get squished down to nothing when the graph includes the more recent numbers that are, indeed, much larger nominal values.

Now let's go back again to the graph that goes all the way to year 2000. Graph #1. Let's keep that blue line as is, and put the same debt data on there again -- this time in red. But this time we'll take that red line, annual change in the Federal debt, and take the inflation out of it.

I divided the annual deficits by the GDP Deflator. It's the same exact calculation you would do to convert nominal GDP to inflation-adjusted GDP. Except of course the data we start with is deficits, not GDP. Here is the result:

 Graph #4: Annual Deficits (blue) from Graph #1, and the Same Deficits with Inflation Stripped Away (red)
With inflation stripped away, the deficits are higher. Doesn't that strike you as odd? It always bothers me. Inflation makes prices higher, so when When you take inflation out of the numbers, the numbers should be lower.

The reason the numbers are higher is that we're looking at years before the "base year". The base year is 2009. (It's not even on the graph.)

Here's the thing: In the years after 2009, the dollar was worth less because of inflation, so the red line is lower than the blue. But in the years before 2009, the dollar was worth more than a dollar in 2009. So the red line is higher. Simple, right?

I hate it.

The years after the base year are okay. The numbers with inflation in them are higher than numbers without. That makes sense. But in the years before the base year, numbers with inflation in them are lower.

Look: I can explain it and convince myself that it is right. That's not the problem.The problem is, every time there is a graph that compares real values and nominal values, I need the explanation to go with it. Explanations make people's eyes glaze over, and they lose interest. I lose interest.

The confusion arises from the base year. The base year is too recent, too close to the present day. The base year needs to be back at the start of the data. Then we would be looking at the years since the base year, and we would see inflation pushing the numbers up. And there would be none of this confusion about inflation making prices lower in the years before the base year.

At the start, prices were X. Since that time, prices went up. Now, that's simple. You don't have to have an explanation to make it make sense. So I want to push the base year back to an early date. That's just the opposite of what economists do, of course.

Suppose I take Graph #4, the real-and-nominal comparison graph, and change the base year from 2009 to 1958. Why 1958? Because when I first started looking at economic data in the 1970s, the base year was 1958. So I'll keep it there.

I'll just keep it there. When you take the inflation out of a data series, you divide that series by the deflator series. And then you multiply by 100 to bring all the numbers up and make the base year right. That's because the base year is always given the value 100. (You can see it on Graph #4, the text in the left-hand border, we are dividing by Index 2009=100. They set up the deflator so that 2009 has the value 100.

Other years have other values. In particular, the year 1958 has the value 17:

 Graph #5: Values of the GDP Deflator

It happens to be a nice round number, but that doesn't matter.

So what I'm gonna do is, instead of multiplying by 100 to bring the adjusted numbers to the 2009 level, I'm going to multiply by 17 to bring those numbers up to the 1958 level. We're still looking at the most recent deflator values, but I'm changing the base year from 2009 to 1958:

 Graph #6: Federal Deficits (blue) with Inflation Removed (red) Base Year=1958

Compare the top blue borders of Graph #6 and Graph #4. They are the same except for the first number on the second line. On Graph #6 I am multiplying by 17, to bring the red line values up to the level of 1958 dollars. On Graph #4 I am multiplying by 100 to bring the red line values up to the level of 2009 dollars.

On Graph #4, multiplying by 100 makes the red line higher than the blue line. That's what happens when you're looking at years before the base year.

On Graph #6, it is as if you are standing in 1958 and looking at two different futures. The red line shows Federal deficits with no inflation. The blue line shows Federal deficits with the inflation that we actually ended up with.

There are two areas on Graph #6 that I want you to look at. The area between the black line (the zero level) and the red line represents increases in Federal deficits for reasons other than inflation. Policy decisions and such.

The area between the blue line and the red line represents increases in Federal deficits that were due entirely to inflation.

So now I can draw a conclusion or two: Yes, inflation pushes new borrowing up. Between the mid-1960s and the early 1980s, inflation pushed the blue line up noticeably. Before the mid-1960s, the red and blue lines are indistinguishable.

Oddly however, the big increase occurs after the early 1980s.

The rate of inflation fell a lot in the early 1980s. But the dollar was worth much less after we had the inflation, than it was before. What was a \$100 deficit in 1965 grew to \$300 twenty years later, solely because of inflation. That's based on the GDP Deflator (which records less inflation than the CPI, for example).

Oh, sure, even with inflation stripped out of them, the deficits increased. The red line shows it. At the time of the 1982 recession the red line makes a big jump -- or, it would look like a big jump if the blue line wasn't there for comparison.

But if you take a big jump in Federal deficits, and multiply it times three to show the effect of inflation, well now you are seeing what looks like an "explosion" of deficits.

//

Yesterday I said:

Inflation pushes new borrowing up, but does nothing to existing debt, so it creates the illusion that deficits are exploding.

Maybe you can see it, on that last graph.